Measuring the Risk of Bond Default

Bond investors in the UK worry about risk and in particular the chance of issuers defaulting on their bonds (which usually means that bond investors don’t get their money back). Therefore, concerns about default (plus future inflation rates) have a huge impact on bond pricing.

In fact, many bond investors are more paranoid than virtually any other kind of investor and are reluctant to take on extra risks.

Unlike most equity investors, who accept risks such as shares going up and down and companies stopping and restarting dividends in return for potential extra returns, bonds are supposed to be safer and less volatile in terms of price – which also helps explain why returns on bonds have been more modest over the last few decades.

Unsurprisingly, therefore, investors in bonds require reliable ways of measuring risk. Credit-risk measurement is available through the research of a number of different credit rating agencies – namely S&P, Moody’s and Fitch.

Each of the agencies has its own specific measures and methodology, but all produce ratings that tend to cluster together and roughly mean the same thing. This table compares the ratings as they move from the highest grade (safest), which is usually AAA, through to the lowest grade, which is a company in default (usually marked C or D).

These ratings can change over time. For example, the government of South Korea found itself downgraded from AA‒ to BBB‒ in just a few years.

Central to this dynamic process is regular research. Here’s S&P’s research process in some detail:

Issuer requests a rating prior to sale or registration of a debt issue.

S&P analysts conduct basic research, including meeting issuers to review in detail the key operating and financial plans, management policies and other credit factors that impact the rating.